Opportunistic Transactions: Distressed Investing Mastery Lesson 5

Lesson Five: Bankruptcy & Debtor-in-Possession Financing

Any borrower can pursue bankruptcy as an option to avoid foreclosure. A borrower that files for bankruptcy typically needs more time and new financing to complete the project. In this situation the lender typically seeks to have the bankruptcy lifted so as to proceed with foreclosure.

If a lender is successful in a foreclosure sale, avoids a borrower bankruptcy, and bids for the property, then the property becomes real-estate owned (REO) on the lender’s books. In this lesson, we will discuss the basics of bankruptcy and REO financing.

5.1 Bankruptcy

There are several bankruptcy basics that you need to be aware of. The first is the special-purpose entity. Lenders typically insist that all loans be granted to special-purpose entities. During bankruptcy or foreclosures, single-purpose entities allow the lender and the courts to focus on one asset only. Without a single-purpose entity, the lender risks bringing other creditors into the bankruptcy proceedings. The second bankruptcy basic is the real project equity. If a property is proven to have real equity, then the sponsor has an opportunity to present a new repayment plan to the bankruptcy court. This plan might not be to the liking of the lender. In these situations, the sponsor typically seeks to “cram down” a lower interest rate and a longer term of repayment than the lender might otherwise like.

The bankruptcy plans are also important to consider. In every bankruptcy the borrower must submit a plan. This plan must depict equity in the property and demonstrate how the borrower can pay off the creditors. The bankruptcy plan is typically a fight in which the borrower attempts to show value and a repayment plan; the lender then attempts to show equity value, and they seek to dismiss the bankruptcy and proceed with the foreclosure. In rare cases, the lender asks the court to throw out the bankruptcy filing due to of lack of merit.

Even though no one involved ever wants to experience a bankruptcy, many deals are designed with that possibility in mind. For example, lenders typically insist that all loans be made to single purpose entities. In the event of bankruptcy or foreclosure, single purpose entities will allow the lender and the courts to focus on one asset specifically. Without a single purpose entity, the lender risks bringing other creditors into the bankruptcy proceedings.

One such tactic that lenders use in these cases is called the “motion to lift stay.” This is where the lender asks the court to “throw out” the bankruptcy filing due to lack of merit – although this rarely occurs.

5.2 Bankruptcy Themes

In real estate bankruptcy cases, there are typically several recurring themes. The first is that the borrower seeks to show equity value above the lender’s loan. A borrower that is able to show equity value has a higher chance of having a second-chance plan approved. The second theme is that the lender seeks to get out of bankruptcy court as quickly as possible – as this is expensive and has no benefit for the lender. The lender attempts to discredit the borrower’s plan and prove that there is no equity in the asset.

The third theme is that lenders seek to consolidate all secured creditors to act and vote as a group. A unified group of secured creditors helps the lender and hurts the borrower’s chances of getting a plan approved. The fourth theme is that although the right to bankruptcy cannot be negotiated away, lenders can give incentive to borrowers to not file for bankruptcy.

5.3 Secured vs. Unsecured Creditors

Every bankruptcy has a secured creditors committee and an unsecured creditors committee, who negotiate and agree (or disagree) on the proposed restructuring plan for each class of creditor. Secured creditors have a recorded lien on the asset. This lien can be a first, second, or third trust. These lenders are treated with priority in a bankruptcy proceeding. And while they make up the secured creditors committee, secured creditors cannot be segregated by lien position; thus, most first-trust lenders seek to limit other secured creditors.

Unsecured creditors are people or companies without a secured lien who are owed money by the bankruptcy entity. These creditors are in line to be paid after the secured creditors, and they typically receive pennies on the dollar in a bankruptcy case.

5.4 Other Bankruptcy Actions

There are two special bankruptcy actions that need to be discussed. The first is the cram-down. This occurs when the borrower convinces the bankruptcy court to allow for a second chance, and when they force the secured creditors to agree to a new transaction (to which they otherwise would not have agreed). The second action is the debtor-in-possession financing. This is when a new lender loans money to the entity that is in bankruptcy. This is a safe loan because it is approved by the courts and holds repayment priority over the bankrupt loans.

You may not have realized this, but in addition to involuntary bankruptcy there is voluntary bankruptcy. This occurs when the creditors file for the lack of repayment, and they can essentially force the borrower into bankruptcy. In most states, at least three creditors must act together in order to achieve this.

A “white knight” transaction refers to a third party who comes into the transaction in the 11th hour, with cash to assist with the negotiated settlement between the lender and the borrower. A “white knight” is typically a new equity partner or lender who will receive profit participation or ownership interest for contributing money quickly and at a critical time. They may also be the new borrower or sponsor who buys an REO property from a lender that needs to get the asset off their books.

5.5 Bankruptcy Reorganization Plan

Below is a diagram of how a reorganization plan works. This plan is carried out under oversight of the U.S. Trustee and the court.

The debtor has a 120-day period in which they have the exclusive right to file a plan. This period of 120 days can be extended to 18 months via court approval. After the exclusive period has expired the creditor can file a competing plan, which provides incentives for the debtor to file a plan within the exclusivity period.

For chapter 11 cases, implementation of the reorganization plan drives the success of the chapter 11 case. Without prior approval from the courts, the debtor can do the following:

  1. 1. Sell the property
  2. 2. Use the property
  3. 3. Lease the property

If the sale or use is outside the course of business, the debtor needs permission from the courts.

Creditors require adequate protection to protect the value of creditors’ interest in the property being used in the DIP. This is especially true in decreased value property cases. Part of this protection could be period lump sum payments to the creditors or additional lien holders, although this is very unlikely in tough markets.

DIPs will need operating capital to continue to run the business. The source of this capital is a super-priority bridge loan. No one but the court has the power to approve such a loan and grant it super-priority status over other secured and unsecured creditors.

5.6 Mechanics of DIP in Commercial Real Estate

Debtor-in-possession financing is a special form of financing granted to companies in financial trouble. For this type of financing, the debtor needs to obtain permission from the existing lender. DIP financing is intended to execute a key event that will allow the business (real estate) to function better than it would have without the financing.

Let’s take a closer look at how the DIP process works. There are three important classifications for claims. The first includes Impaired Claims. These are creditor claims, for those whose contract rights are to be modified (paid less than the full value of claims under the plan). This process is voted on via ballot.

The second includes the Disclosure Statement. This document contains information about assets, liabilities, and business affairs of the debtor, sufficient enough for a creditor to make a decision or judgment about the debtor’s reorganization plan. The contents will include the classification of the claims and they will specify how each class of claims will be treated under the plan. Once the Disclosure Statement is approved and the ballots are collected and tallied, the court will conduct a confirmation hearing to confirm the plan.

Finally, we have the Unimpaired Claims. These are claims that are not modified. These are typically the senior loans in the capital stack.

5.7 Guidelines for Chapter 11 Debtor-in-Possession Financing Arrangements

Now, you’re undoubtedly going to come across some opportunities that require debtor-in-possession financing. Here’s the information you’ll need before you speak to a capital provider or a private investor: First will be a copy of the original partnership operating agreement and other entity documents. You’ll also need a copy of the bankruptcy filing itself. After that you’ll need the financials of the property, as well as the details of the debt stack. You should also determine how the DIP loan will be used, along with what the proposed plan of action will be once the property is out of bankruptcy.